Your humble scribe is scheduled to be on CNBC Squawk Box on Tuesday, January 17th ~ 8:00 ET to talk about the large bank earnings parade, especially Wells Fargo (WFC) and Citigroup (C). As with the earlier missive about JPMorgan’s (JPM) earnings, the operative paring of factors for C and WFC is better earnings on down revenue and business volumes. Send any comments to Ben Bernanke at the Federal Reserve Board in Washington. But why is C trading at half the multiple of WFC?
If you refer to the last 10-Q for WFC, for example, < http://www.sec.gov/Archives/edgar/data/72971/000119312511301024/d239752d... > total interest income was down a billion dollars to $12.1 billion YOY. Interest expense fell $400 million in the same period, but overall net interest income (NII) fell YOY. While for several years the Fed has been able to support the cash margin on reduced revenue flows through the big banks, cash NIM is finally starting to compress with a vengeance thanks to Fed zero rate policy.
The key change for WFC that is taking results up YOY is reduced costs for credit loss provisions, only $1.8 billion in the first nine months of 2011 vs. $3.4 billion in 2010. So NII after provisions at WFC was up $1 billion at the end of Q3 2011. You with me?
A $400 billion loss from trading activities pulled total noninterest income down but somehow WFC cut $500 million in non-interest operating expenses. That’s what allowed WFC to hit a $600 million increase in net income for Q3 and up more than $2.5 billion for the nine months through September 2011 vs. the year before to $11.1 billion. So we have down net interest income, but up NII after provisions for loan losses.
At $30 on Friday close, WFC is trading 1.25 times book or about a 9 forward PE with a beta of 2, above the large bank average beta of 1.8. Of note, the subsidiary banks of WFC were rated “A” by IRA at the end of Q3 2011 and the enterprise had a risk adjusted return on capital of 2.6%. You can look up the ratings for your bank or any US bank at www.irabankratings.com.
By comparison with WFC, the bank subsidiaries of C were rated just “C” by The IRA Bank Monitor in Q3 2011, mostly due to the default rate 2x the industry average and more aggressive posture on Exposure at Default. Citigroup is trading on a 9 forward PE, but at just 0.5 times book and all this with a nosebleed market beta of 3. < http://www.sec.gov/Archives/edgar/data/831001/000104746911009017/a220610...
C like WFC saw a sharp, 8% drop in NII in Q3 2011 as the effect of Fed low interest rate policy forced a downward re-pricing of assets. For the first nine months of 2011, C’s NII was down 12% to just $36 billion. Non-interest revenue was up more than $1 billion, offsetting the shrinkage in income from earning assets.
Unlike WFC, operating expenses at C rose almost $1 billion in Q3 2011 vs. Q3 2010, but sharply lower credit loss provisions at $3.3 billion vs. almost $6 billion the year before let C turn in a 74% or $1.7 billion YOY increase in net income in Q3 2011. For the first nine months C was up 9% to $10.1 billion, including $1.8 billion in favorable adjustments due to the wonders of fair value accounting.
My friend Dick Dove thinks that a revitalized C could explode on the upside, as we discussed on Bloomberg TV last week with Tom Keene < http://www.bloomberg.com/video/84060982/>. Bove likes the piles of cash at C, but of course C, being a bank, most of this cash belongs to somebody else.
But the fact remains that the markets today value a $1 of C revenue and earnings at half the equity multiple of WFC and trade the C equity like an option with a market beta of 3. Only when C starts to tells us why this new, slimmer business model makes sense compared with its asset peers is the comparative valuation gap likely to shift IMHO.
I continue to believe that the difference between the valuation of WFC and C is actually about right and is a function of the high-risk business model at C. Say what you want about the piles of cash, Dick Bove, C has a gross yield on lending assets that is more than 350bp above the industry average, a function of a subprime internal default target for the average customer. This is a deliberate business model choice and one that, frankly, makes it hard for me to justify buying C.
The risk-reward equation at C is a tad light on remuneration for buy and hold investors and always has been, but as a high beta trading vehicle for hedge funds, C is the perfect date. One reason why WFC has been so much more stable than its similarly sized peer C is that the bank continues to have a very loyal and stable shareholder base, even though WFC has some considerable legacy issues in real estate. But frankly the visibility on 2012 revenue at WFC is not a lot better than at C.